What You Need To Know To Invest In Cannabis Companies

The following article is part of a package of stories that MarketWatch is publishing to mark the start of full legalization of cannabis for adult use in Canada on Wednesday.

Stocks of marijuana businesses have been on a rampage in anticipation of billions of dollars’ worth of sales and other opportunities as Canada this Wednesday becomes the first G-7 nation to legalize cannabis.

Like any hot and relatively new sector, the cannabis industry can be confusing, with high potential for scams, as the Securities and Exchange Commission has warned, so investors need to know the basics. To start with, there are a handful of large companies that actually touch the marijuana plant — an important distinction — and there are metrics that are unique to the industry that can help investors understand the underlying business.

There are six large public cannabis companies that demand attention: Aphria Inc. APHQF, +4.78% APH, +4.13% , Aurora Cannabis Inc. ACBFF, +11.03%ACB, +9.92% , Cronos Group Inc. CRON, +19.07% CRON, +18.46% , Canopy Growth Corp. CGC, +14.24% WEED, +13.64% , GW Pharmaceuticals PLC GWPH, -0.06% and Tilray Inc. TLRY, +11.69%TLRY, +11.69% . Five are Canadian and trade on the Toronto Stock Exchange and on U.S. exchanges or on the over-the-counter market, while one is U.K.-based.

All produce thousands of kilograms of weed each quarter, which is critical, as there are dozens of smaller businesses both public and private that have yet to bring products to market. Some of those are expected to die, and some are expected to thrive.

As Canadian legalization approaches, MarketWatch is profiling each of these six companies, touching on the metrics discussed below, to give investors a clearer picture of their businesses:

We are also rounding up others that could grow to challenge these companies, and some that will offer products or services connected to marijuana that don’t involve selling weed-based products.

As with any business, the top and bottom lines are critical measures of success for cannabis companies. Of the largest five producers in Canada by market capitalization (GW Pharmaceuticals is based in the U.K.), all have made medical sales, but some are not yet profitable. With recreational pot looming, Canadian companies are making big bets to capture the estimated one billion Canadian dollars — or US$771 million — in sales that will occur through the end of the year. But they can’t stay unprofitable forever.

Beyond profit and sales, there are five other criteria that investors should watch closely when evaluating companies in the industry.

What business are they in?

Eventually, some cannabis companies will probably specialize in either medical or recreational marijuana. At the moment, for pot producers large and small in Canada, they are all medical-cannabis businesses — or not making sales at all.

There is a sophisticated, existing system to produce and distribute medical pot throughout the country and for export. What remains to be seen after Oct. 17 is which companies will be able to succeed in the recreational market. There is no guarantee that any will become the Coca-Cola of pot, and some may remain more successful at selling medical cannabis.

Not all of the companies interested in making money from marijuana, in fact, are looking at the recreational market, and some, such as GW Pharmaceuticals, are shaping up to be something that’s more akin to a drug company than a recreational-cannabis producer.

How much cannabis are they growing and at what cost?

Every major Canadian producer breaks down in its quarterly financial statements how much pot it has actually grown and how much pot it has sold. These are critical numbers because they demonstrate that the company can grow and sell the once-illegal product.

As in the cases of most businesses, it’s important for investors to be able to determine the cost of a product versus how much it’s being sold for. There is no standard way to do so. Canadian regulators are not happy with the current level of disclosure related to per-gram costs, among other reporting issues. In a notice sent Oct. 10, the Canadian Securities Administrators said the current method that many pot producers use to calculate per-gram costs was not clear and companies need to offer more detail.

Several pot businesses use the cost-per-gram metric, but it’s not a perfect number, and it’s not always clear which inputs are included. Some companies don’t disclose the metric at all; at least one breaks it down further to “cash cost” per gram. If a company does include per-gram prices, investors should compare changes from quarter to quarter, but, since it’s not a standard number, it’s important to tread carefully when comparing companies.

For all cannabis companies, one of the most significant inputs is energy, since cannabis is an energy-intensive product that requires as much sunlight as a vineyard. Low growing costs also correlate closely with the bottom line. In a CIBC research note earlier this year, analysts were assuming a roughly 60% gross margin and assuming producers can capture about C$3.60 per gram in revenue from government buyers.

How much cannabis can companies grow?

While some major cannabis producers are already profitable businesses, the introduction of recreational cannabis is expected to shift demand from the black market into the hands of legal businesses. With CIBC predicting C$6.5 billion in retail sales by 2020, companies are likely going to be able to sell much more pot than they are currently producing, so the question is how much they are planning to produce in the future.

Most large producers disclose their square footage under cultivation, as well as how much they are licensed by the Canadian government to produce. Investors should look at how much new capacity they are building, so they can figure out at what point the company will have to use capital to expand.

What supply agreements do they have?

This is where the money is, at least for now. Cannabis companies have been signing agreements to supply marijuana, both in Canada and beyond.

Licensed weed producers are regulated by Health Canada, the federal ministry that grants the certification to grow cannabis. Canadian legislation has left the provinces to determine how pot will be distributed, however, similar to how the country handles alcohol sales.

While each province has set up the rules for cannabis sales slightly differently, the agreements the various provincial entities have struck with weed producers are critical. The information provinces offer is helpful but incomplete. They have announced supply agreements but few details about actual purchases. Some provinces and companies have released the maximum amount of cannabis under the agreement the province will buy, but there is no guarantee that number will be reached. All the provinces list the suppliers on their websites, though for international deals securities filings with SEDAR, Canada’s version of the U.S. Securities and Exchange Commission’s EDGAR regulatory filing system, is the best bet.

What neither companies nor the government know at the moment is what people around Canada will actually buy, which products will be successful, or which brands will attract consumers. While every producer will make money from the first round of sales to various provincial authorities, in the long run nobody knows who will succeed.

Beyond domestic sales in Canada, there are an increasing number of opportunities to export cannabis or set up shop inside countries that have legalized medical marijuana. Most major Canadian companies have some overseas interests, whether they be supply agreements or growing facilities, especially in large, sophisticated medical markets such as Germany’s. Deals with international pharmaceutical companies for distribution are also worth noting.

What intellectual property do they own?

Canada’s medical-marijuana system has existed for years, but adult recreational use has spurred something of an arms race to develop and patent new ways of growing, refining and processing the plant. Some companies disclose their number of patents, and some don’t, but companies with intellectual property that other companies will want to license should see a boost in their valuations.

The key, as in other sectors, is that investors should look for companies that develop a technology that is best-in-class or fundamental to the future of the cannabis sector, one that competitors will have to pay to use.